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HPQ > SEC Filings for HPQ > Form 10-Q on 11-Mar-2014All Recent SEC Filings

Show all filings for HEWLETT PACKARD CO

Form 10-Q for HEWLETT PACKARD CO


11-Mar-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of
Financial Condition and Results of Operations

This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is organized as follows:


Overview. A discussion of our business and overall analysis of financial and other highlights affecting the company to provide context for the remainder of MD&A.


Critical Accounting Policies and Estimates. A discussion of accounting estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results.


Results of Operations. An analysis of our financial results comparing the three months ended January 31, 2014 to the prior-year period. A discussion of results of operations at the consolidated level is followed by a more detailed discussion of results of operations by segment.


Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and a discussion of our financial condition and liquidity.


Contractual and Other Obligations. Overview of contractual obligations, retirement and post-retirement benefit plan funding, uncertain tax positions, restructuring plans and off-balance sheet arrangements.

We intend the discussion of our financial condition and results of operations that follows to provide information that will assist in understanding our Consolidated Condensed Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Condensed Financial Statements. That discussion should be read in conjunction with our Consolidated Condensed Financial Statements and the related notes that appear elsewhere in this document.

OVERVIEW

We are a leading global provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses ("SMBs") and large enterprises, including customers in the government, health and education sectors. Our offerings span the following:
personal computing and other access devices; imaging and printing-related products and services; enterprise IT infrastructure, including enterprise server and storage technology, networking products and solutions, technology support and maintenance; multi-vendor customer services, including infrastructure technology and business process outsourcing, application development and support services, and consulting and integration services; and IT management software, information management solutions and security intelligence/risk management solutions. We have seven reportable segments for financial reporting purposes:
Personal Systems, Printing, the Enterprise Group ("EG"), Enterprise Services ("ES"), Software, HP Financial Services ("HPFS") and Corporate Investments.


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The following provides an overview of our key financial metrics by segment:

                                            Printing and Personal
                                                Systems Group
                        HP            Personal                            Enterprise    Enterprise                                  Corporate
                  Consolidated(1)      Systems    Printing      Total        Group       Services       Software       HPFS       Investments(2)
                                                    In millions, except per share amounts
Three Months
Ended
January 31,
2014
Net revenue        $        28,154     $  8,530    $  5,815    $ 14,345    $    6,993    $    5,595    $      916    $    870      $          288
Year-over-year
(decrease)
increase %                    (0.7 )%       3.6 %      (2.2 )%      1.2 %         0.6 %        (7.3 )%       (3.7 )%     (9.1 )%               NM
Earnings from
operations         $         1,997     $    279    $    979    $  1,258    $    1,006    $       57    $      145    $    101      $          121
Earnings from
operations as
a % of net
revenue                        7.1 %        3.3 %      16.8 %       8.8 %        14.4 %         1.0 %        15.8 %      11.6 %              42.0 %
Year-over-year
increase
(decrease)
percentage
points                      0.9pts       0.5pts      0.5pts      0.3pts      (1.0)pts      (0.3)pts      (0.5)pts      1.0pts                  NM
Net earnings       $         1,425
Net earnings
per share
Basic              $          0.75
Diluted            $          0.74


--------------------------------------------------------------------------------
    (1)


HP consolidated net revenue excludes intersegment net revenue and other. HP consolidated earnings from operations includes corporate and unallocated costs and eliminations, unallocated costs related to stock-based compensation, amortization of intangible assets, restructuring charges and acquisition-related charges.

(2)
"NM" represents not meaningful.

Net revenue declined 0.7% (increased 0.3% on a constant currency basis) in the three months ended January 31, 2014, as compared to the prior-year period. The leading contributor to the net revenue decline was key account runoff in ES and unfavorable currency impacts, particularly weakness in the Japanese yen. Partially offsetting the net revenue decline was growth in Personal Systems commercial PCs as well as the sale of a portfolio of mobile computing intellectual property ("IP") which benefited the Corporate Investments segment and to a lesser extent Personal Systems. Gross margin increased by 0.5 percentage points in the three months ended January 31, 2014 due primarily to the sale of IP, gross margin improvement in Printing due to favorable currency impacts along with a favorable inkjet supplies mix, and service delivery efficiencies in ES. At the same time, we continue to experience gross margin pressures resulting from a competitive pricing environment across each of our hardware segments. Operating margin increased by 0.9 percentage points in the three months ended January 31, 2014 due primarily to the gross margin increase, lower selling, general and administrative ("SG&A") expenses and lower levels of intangible asset amortization. The decline in SG&A was due primarily to a gain from the sale of real estate and cost savings associated with our ongoing restructuring efforts, partially offset by higher litigation-related reserves.

Our business continues to produce significant cash flow from operations, generating $3.0 billion in the three months ended January 31, 2014. Additionally, we issued $2.0 billion of long-term debt, made a $547 million net investment in property, plant and equipment, repurchased $565 million worth of common stock, and returned $278 million to stockholders through dividends. As of January 31, 2014, our investment portfolio was $16.4 billion, consisting of cash and cash equivalents and short-term and long-term investments, which was an increase of approximately $3.9 billion from the October 31, 2013 balance of $12.5 billion.

As we entered fiscal 2014, we continued to experience challenges that represent trends and uncertainties that may affect our business and results of operations. One set of challenges relates to continuing dynamic and accelerating market trends. Another set of challenges relates to changes in the competitive landscape. Our major competitors are expanding their product and service offerings with integrated products and solutions, our business-specific competitors are exerting increased competitive pressure in targeted areas and are going after new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and


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our go-to-market execution. In addition, we are continuing to experience macroeconomic weakness across many geographic regions. A discussion of some of these challenges at the segment level is set forth below.


In Personal Systems, we continue to be negatively impacted by the market shift towards tablet products within mobility products, which has reduced the demand for consumer and notebook products. If benefits from our new product investments in this area do not materialize, we will continue to be negatively impacted by this trend. Personal Systems is also being impacted by consumer demand weakness and a competitive pricing environment. However, the pace of market contraction is slowing with signs of stabilization. In the first quarter of fiscal 2014, Personal Systems revenue increased due to growth in commercial PCs, particularly notebooks.


In Printing, we are experiencing the impact of the growth in mobility, weak consumer demand as well as an overall competitive pricing environment. To be successful in addressing these challenges, we need to execute on our key initiatives of focusing on products targeted at high usage categories, developing emerging market opportunities, and introducing new revenue delivery models to consumer customers.


In EG, we are experiencing revenue growth challenges due to multiple market trends and a highly competitive pricing environment, including the increasing demand for hyperscale computing infrastructure products and the transition to cloud computing. In addition, the market for our Business Critical Systems ("BCS") products continues to weaken as the overall market for UNIX products and services contracts. To be successful in overcoming these challenges, we must address business model shifts and go-to-market execution challenges, including improved channel execution, and continue to pursue new product innovation, such as HP Moonshot servers, 3PAR storage and the HP CloudSystem and in areas such as software-defined networking, blade servers and wireless networking.


In ES, we are facing internal execution challenges, pressured public sector spending, a competitive pricing environment, and market and macroeconomic pressures. To be successful in addressing these challenges, we must execute on our multi-year turnaround plan, which includes a cost reduction initiative to align our costs to our revenue trajectory and initiatives targeted at improved execution in the areas of sales performance and accountability, contracting practices and pricing.


In Software, we are facing multiple challenges, including the market shift to SaaS and go-to-market execution challenges. To be successful in addressing these challenges, we must improve our go-to-market execution with integrated customer solutions more aligned to customer demand and achieve broader integration across our overall product portfolio as we work to capitalize on the important market opportunities in the areas of cloud, big data, security and mobility.

To address these challenges, we continue to pursue new product innovation with a view towards developing new products and services aligned with market demand, industry trends and the needs of our customers and partners. In addition, we need to continue to improve our operations, with a particular focus on enhancing our end-to-end processes and efficiencies. We also need to continue to optimize our sales coverage models, align our sales incentives with our strategic goals, improve channel execution, strengthen our capabilities in our areas of strategic focus, and develop and capitalize on market opportunities.

For a further discussion of trends, uncertainties and other factors that could impact our operating results, see the section entitled "Risk Factors" in Item 1A, which is incorporated herein by reference.


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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management's Discussion and Analysis of Financial Condition and Results of Operations is based on our Consolidated Condensed Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenues and expenses, and disclosure of contingent liabilities. Management believes that there have been no significant changes during the three months ended January 31, 2014 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013.

ACCOUNTING PRONOUNCEMENTS

For a summary of recent accounting pronouncements applicable to our consolidated condensed financial statements see Note 1 to the Consolidated Condensed Financial Statements in Item 1, which is incorporated herein by reference.

RESULTS OF OPERATIONS

Set forth below is an analysis of our financial results comparing the three months ended January 31, 2014 to the three months ended January 31, 2013. Unless otherwise noted, all comparative performance data included below reflect year-over-year comparisons.

Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our revenue growth has been impacted, and we expect will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing how each of our segments performed excluding the impact of foreign currency fluctuations, we present the year-over-year percentage change in revenue on a constant currency basis, which assumes no change in the exchange rate from the prior-year period. This information is provided so that revenue can be viewed without the impact of fluctuations in foreign currency rates, which is consistent with how management evaluates our operational results and trends. This constant currency disclosure is provided in addition to, and not as a substitute for, the year-over-year percentage change in revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes.


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Results of operations in dollars and as a percentage of net revenue were as follows:

                                                 Three months ended January 31
                                                  2014                   2013
                                                        % of                   % of
                                           Dollars    Revenue     Dollars    Revenue
                                                          In millions
     Net revenue                           $ 28,154      100.0 %  $ 28,359      100.0 %
     Cost of sales(1)                        21,736       77.2 %    22,029       77.7 %


     Gross profit                             6,418       22.8 %     6,330       22.3 %
     Research and development                   811        2.9 %       794        2.8 %
     Selling, general and administrative      3,210       11.4 %     3,300       11.6 %
     Amortization of intangible assets          283        1.0 %       350        1.2 %
     Restructuring charges                      114        0.4 %       130        0.5 %
     Acquisition-related charges                  3          -           4          -


     Earnings from operations                 1,997        7.1 %     1,752        6.2 %
     Interest and other, net                   (163 )     (0.6 )%     (179 )     (0.6 )%


     Earnings before taxes                    1,834        6.5 %     1,573        5.6 %
     Provision for taxes                       (409 )     (1.4 )%     (341 )     (1.3 )%


     Net earnings                          $  1,425        5.1 %  $  1,232        4.3 %


(1)
Cost of products, cost of services and financing interest.

Net Revenue

For the three months ended January 31, 2014, total HP net revenue decreased 0.7% (increased 0.3% on a constant currency basis). U.S. net revenue decreased 4.7% to $9.7 billion, while net revenue from outside of the United States increased 1.5% to $18.5 billion. The net revenue decline was due primarily to key account revenue runoff in ES and unfavorable currency impacts, particularly weakness in the Japanese yen, partially offset by increased commercial revenue in Personal Systems and net revenue in Corporate Investments from the sale of IP.

The components of the weighted net revenue change were as follows:

                                                  Three months
                                                     ended
                                                  January 31,
                                                      2014
                                                   Percentage
                                                     Points
                   Enterprise Services                     (1.6 )
                   Printing                                (0.5 )
                   HP Financial Services                   (0.3 )
                   Software                                (0.1 )
                   Enterprise Group                         0.2
                   Corporate Investments/Other              0.5
                   Personal Systems                         1.1


                   Total HP                                (0.7 )


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From a segment perspective, the primary factors contributing to the revenue change are summarized as follows:


ES net revenue declined due primarily to key account revenue runoff, contractual price declines in ongoing contracts and unfavorable currency impacts;


Printing net revenue declined due to lower volumes of toner supplies, lower average revenue per unit ("ARUs") and unfavorable currency impacts;


HPFS net revenue decreased due primarily to lower buyout activity, lower rental revenue from a decrease in average operating lease assets, along with lower finance income from a decrease in average finance lease assets;


Software net revenue declined due primarily to the overall market and customer shift to SaaS which is impacting growth in license and support;


EG net revenue increased due primarily to improved demand in the Industry Standard Servers ("ISS") and Networking business units;


Corporate Investments net revenue increased due to the sale of IP; and


Personal Systems net revenue increased due to growth in commercial PCs.

A more detailed discussion of segment revenue is included under "Segment Information" below.

Gross Margin

Our total gross margin increased 0.5 percentage points for the three months ended January 31, 2014. Gross margin increased across all of our segments, except EG and Personal Systems. The primary factors impacting gross margin performance for each of our segments are summarized as follows:


ES gross margin increased due primarily to service delivery efficiencies;


Printing gross margin increased due primarily to favorable currency impacts from the Japanese yen and a higher mix of ink and graphics supplies;


HPFS gross margin increased due primarily to higher portfolio margin from a lower cost of funds, higher margins on asset management activity, along with lower bad debt expense;


Corporate Investments gross margin increased due to the sale of IP;


Software gross margin increased due primarily to a higher mix of support revenue and lower mix of lower-margin professional services revenue;


EG experienced a gross margin decline due primarily to competitive pricing pressures and higher memory component costs; and


Personal Systems experienced a gross margin decline due primarily to increased memory component costs and unfavorable currency impacts.

A more detailed discussion of segment gross margins and operating margins is included under "Segment Information" below.

Operating Expenses

Research and Development

Research and development ("R&D") expense increased in the three months ended January 31, 2014 as we continue to invest in innovation in our strategic focus areas such as cloud, and across many of our business segments.


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Selling, General and Administrative

Selling, general and administrative ("SG&A") expense decreased in the three months ended January 31, 2014 due primarily to a gain from the sale of real estate and cost savings associated with our ongoing restructuring efforts. The decrease was partially offset by higher litigation reserves and investments in system and tools.

Amortization of Intangible Assets

Amortization expense decreased for the three months ended January 31, 2014 due primarily to certain intangible assets associated with prior acquisitions reaching the end of their amortization periods.

Restructuring

Restructuring charges decreased for the three months ended January 31, 2014, due primarily to lower charges in the current period from the 2012 Plan. In addition, the prior-year period benefited from a reversal of severance charges related to other restructuring plans.

Interest and Other, Net

Interest and other, net expense decreased by $16 million for the three months ended January 31, 2014. The decrease was driven primarily by lower interest expense due to a lower average debt balance and the prior-year period containing a higher net loss on investments, partially offset by higher currency transaction losses.

Provision for Taxes

Our effective tax rate was 22.3% and 21.7% for the three months ended January 31, 2014 and January 31, 2013, respectively. Our effective tax rate generally differs from the U.S. federal statutory tax rate of 35% due to favorable tax rates associated with certain earnings from our operations in lower-tax jurisdictions throughout the world. We have not provided U.S. taxes for all foreign earnings because we plan to reinvest some of those earnings indefinitely outside the United States.

In the three months ended January 31, 2014, we recorded $22 million of net tax charges related to discrete items. These amounts included $37 million of various tax charges and $15 million of tax benefits on restructuring charges.


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In the three months ended January 31, 2013, we recorded $5 million of net tax charges related to discrete items. These amounts consisted primarily of a tax charge of $150 million related to a past uncertain tax position offset by approximately $50 million of various adjustments to estimated tax provisions of foreign jurisdictions as well as $45 million of benefits associated with restructuring charges, and various uncertain tax positions and valuation allowance adjustments. In addition, in January 2013, the American Taxpayer Relief Act of 2012 was signed into law. We recorded a tax benefit of $50 million arising from the retroactive R&D credit provided by that legislation in the first quarter of fiscal 2013.

Segment Information

A description of the products and services for each segment can be found in Note 16 to the Consolidated Condensed Financial Statements in Item 1, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed.

Effective at the beginning of the first quarter of fiscal 2014, we implemented certain organizational changes to align the segment financial reporting more closely with our current business structure. These organizational changes include:


transferring the HP Exstream business from the Commercial Hardware business unit within the Printing segment to the Software segment;


transferring the Personal Systems trade and warranty support business from the Technology Services ("TS") business unit within the EG segment to the Other business unit within the Personal Systems segment;


transferring the spare and replacement parts business supporting the Personal Systems and Printing segments from the TS business unit within the EG segment to the Other business unit within the Personal Systems segment and the Commercial Hardware business unit within the Printing segment, respectively; and


transferring certain cloud-related incubation activities previously reported in Corporate and unallocated costs and eliminations and in the EG segment to the Corporate Investments segment.

In addition, we transferred certain intrasegment eliminations from the ES segment and the EG segment to corporate intersegment revenue eliminations.

None of these changes impacted our previously reported consolidated net revenue, earnings from operations, net earnings or net earnings per share.

Printing and Personal Systems Group

    The Personal Systems segment and the Printing segment are structured beneath
a broader Printing and Personal Systems Group ("PPS"). We describe the results
of the segments within the Printing and Personal Systems Group below.

Personal Systems

                                                    Three months ended January 31
                                                 2014           2013        % Increase
                                                             In millions
Net revenue                                    $    8,530     $    8,232            3.6 %
Earnings from operations                       $      279     $      233           19.7 %
Earnings from operations as a % of net
revenue                                               3.3 %          2.8 %


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The components of the weighted net revenue change by business units were as follows:

                                               Three months
                                             ended January 31,
                                                   2014
                                             Percentage Points
                   Notebook PCs                             2.5
. . .
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